Margin Rules Raises Mobilizing Collateral Concerns

Global custodians could face issues of mobilizing collateral after new margin rules for swaps traded outside of a clearinghouse are implemented, according to industry experts.

Regulators across the world, including the U.S. Commodity Futures Trading Commission (CFTC) and the International Organization of Securities Commissions (IOSCO), are proposing rules that would set a minimum collateral threshold for privately negotiated swaps trades for banks and major swap dealers.

This will involve the mandatory exchange of both initial and variation margins among participants (i.e. two-way margining). Participants will also have to establish a segregated account with a third-party custodian to hold the collateral for the trade.

However the margin rules for uncleared derivatives underpins concerns of an immobilization of collateral due to differences in international legal frameworks, which could cause significant challenges for custodians.

“What is complex, certainly with Europe, is in legal framework that covers the document. You have to be well versed in the bankruptcy laws for each jurisdiction,” says Nadine Chakar, executive vice president, global collateral services, Bank of New York (BNY) Mellon.

“You need to understand how to move or mobilize your collateral assets while those assets are segregated, without losing the protection that segregation provides.”

According to a joint research paper between the DTCC and the London School of Economics published in June, weaknesses in infrastructure could mean available collateral is immobilized in one part of the system and unattainable by credit-worthy borrowers. This is due to certain restrictions on re-using collateral and risk management techniques deployed by central counterparties (CCPs).

“Our research has found that the challenge does not lie in the global supply of collateral in aggregate, but rather in the accessibility of collateral across market participants,” the report says.

With so many collateral requirements being passed through, custodians are seeing their workload increase dramatically, which could cause a number of operational challenges.

“With custodians becoming a very important part of the collateral management model, keeping track of all the collateral is going to be more challenging,” says Ted Leveroni, executive director of strategy and buy side relations, Depository Trust & Clearing Corporation (DTCC).

“With more complex account structures and more collateral movements to be processed, there are real operational challenges custodians have to face.”

Furthermore, because of the two-way margining standard being proposed for uncleared swaps, valuation margin could cause more frustration and challenges.

“In the U.S. you will only be able to post cash, whereas under EMIR there’s a little more leeway with gold and high quality bonds as options. There are still different regional aspects to the rules and regulations,” adds Chakar.

The rules are expected to come into force in December 2015 for variation margin and a phased compliance schedule for initial margin running from 2015 to December 1 2019 for certain firms.

In the meantime, Leveroni argues to meet these challenges custodians must look to increase automation and adopt messaging standards that will enhance their collateral-specific practices and encourage harmonization.

“Adopting standards relieves you of so many other burdens, and allows you to focus on your core business. If you have a flexible, automated system it allows you to add value on the edges.”